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Saving is the part of personal income that is neither
consumed nor paid out in taxes.
The income saved is canalise to business firms in
two different ways.
(I) Households buy bonds and stocks issued by
business firms, and the firms then use the money
to buy investment goods.
(II) Households deposit saving into the banks. The
banks then lend the money to the firms, which
use it to buy investment goods.
Investment is the portion of final products that adds
to the nation's stock of income yielding physical
assets or that replaces old, worn-out physical assets.
Final goods that business firms keep for themselves
are called private investment or private capital
formation. Private investment consists of inventory
investment and fixed investment.
(I) Inventory investment means goods purchased by the
business firms but not resold to consumers in the
current period, stays in the stock raise the level of
inventories. Inventories of raw materials, parts and
finished goods are essential forms of income yielding
assets for business.
(II) Fixed investment includes all final goods purchased by
business firms other than addition to inventory. It
includes all final goods purchased by business firms
that are not intended to resale. The main types of fixed
investment (investment on capital goods) are structures
(factories, office building, plants and machinery).
First of all coined by Thomas Tooke in 1844.
Further explained by classical economist who believe
on monetarism. This theory is also called as Income
Elaborate and explained by J. M. Keynes in the name
of Saving-Investment Theory
The major objective of this theory is to explain the
changes in price level or the value of money
The classical view states that the economy is always
at full-employment equilibrium.
This theory is termed as “Income Theory.”
The saving and investment are always equal. The
classical economists believe that equality between
saving and investment brought by interest rate.
When, saving exceeds investment, the rate of interest
falls to discourage saving and encourage investment
and vice versa.
Effect on price:
If AY>AO, Price increase
If AY<AO, Price decrease
Therefore, the major cause of change in price is
money income or money supply or the interest rate in
Price = AY/AO
AY = Aggregate Income
AO = Aggregate Output
It shows that there is positive relationship between
interest rate/money supply and price.
Saving and Investment
Keynes disagree with equilibrium of saving and
investment is brought by the rates of interest rather, it is
the changes in the level of income which play a role in
equalization of saving and investment.
Equilibrium (S=I) below full employment in the economy.
Keynes established this equality by using the economy's
equilibrium situation, the economy is said to be in
equilibrium when aggregate expenditure ( AE) is equal to
income of the economy. That is, Y = AE or AD = f(Y)
(Y+ =purchasing power + = AD +)
Effect on price:
◦ If factor of production/resources constraint, increase in price
◦ If no constraint, price level remains same
Therefore, the major cause of change in AD is income
rather than interest rate.
Assuming two sector model, aggregate expenditure equals to
consumption plus investment (I), AE = C + I and national
income (Y) equals to consumption plus saving (S). This gives
saving (S) equals to Investment (I), i.e., S = I.
Equilibrium situation is the situation where S=I.
From income perspective, Y = C + S ………. (1)
From expenditure perspective, Y = C + I ……(2)
So that S = I i.e. state of equilibrium
The changes in Y makes S = I
If I>S, Y increases unless S=I, leads to increase in
price. (when I+, Y also +)
If I<S, Y decreases unless S=I, leads to decrease in
price. (when I-, Y also -)
Note: The state of disequilibrium in the economy does
not last long
It shows the equilibrium of S and I (S = I) at point L.
When, I>S, increase in price level at
SavingandInvestment When, I<S, decrease in price level
at new equilibrium
When investment is greater than saving, the level of
income will also be increased by multiplier process.
This causes to rise saving and equality between then
Similarly, when saving is greater than investment
opposite will occur, i.e. level of income will decrease
which causes saving to decrease. The equality
between saving and investment can exist at below
full employment level.
Saving-Investment theory explain the disequilibrium
between saving and investment causes fluctuation in
price or the value of money by affecting the level of
income. If saving and investment are equal, the price
level is stable.
If the saving exceeds investment price level falls and if
investment exceeds saving, price level increases.
Thus, the price level is the consequence of the change
in income rather than the quantity of money